We all need a little diversity

A fund manager needs to know how to reduce the overall risk of their portfolio, even if they are purchasing risky assets. There are two main ways to do this – hedging and diversification. In this article, we will focus on the latter, diversification. You’ll find this information useful if you are studying for any of the CII investment exams R02, AF4, J10, and J12.

If you were to ask your grandmother, she would no doubt advise you not to put all of your eggs in one basket. It’s obvious that it’s going to be less risky holding a number of shareholdings rather than just one. Diversification reduces risk because combining different asset classes or securities reduces the overall risk to less than the average risk of the individual securities – the downside risk of one investment could be offset by the upside risk of another. However, if all the investments held were to move in the same direction at the same time this would not work – for diversification to be effective, you need investments that move in opposite directions to each other.

The degree of diversification depends on a statistical concept called correlation.

Positive Correlation

Two shares are positively correlated when they broadly move up and down together. They will be affected by similar factors, such as interest rates or consumer demand, and may well be in the same sector.

Negative Correlation

Two shares are negatively correlated when they tend to move in opposite directions from each other – an umbrella retailer and a suntan lotion manufacturer perhaps?

No Correlation

The returns of some companies or asset classes are not connected in any way to each other.

Correlation is measured by the correlation coefficient. Perfect positive correlation has a value of + 1, perfect negative correlation has a value of – 1, and no correlation has a value of zero.

Theoretically, the most effective diversification of risk comes from combining investments that are negatively correlated – one goes up when the other goes down – but this is not always easy to find in practice. Choosing companies in different sectors can help to achieve diversification. Adding companies from overseas markets can also add diversification; however, global equity markets tend to have a moderate to strong positive correlation with each other. Investing in different asset classes, including alternative investments such as property, commodities, and hedge funds can also assist in the overall diversification of a portfolio and hence overall risk reduction.

Grab the resources you need!

If you plan to sit the CII R02 exam, and you’re wondering how you’ll manage to pull off a pass on exam day, grab our free taster to try out one of Brand Financial Training’s mock exam papers for yourself.  Click the link to download the R02 mock exam taster now!

Alternatively, you can download a taster for AF4, J10, or J12 if you’re studying for one of those exams.